Ordinary shares, also addressed as common or equity shares, are stocks floated on a public exchange. The owners of these shares are called shareholders. Ordinary Shareholders hold the right to company’s residual income, which is net profit after tax deduction, in the form of dividends. However, the company may decide against giving out dividends and reinvesting the amount back in business. Shareholders also have the right to vote at the company’s annual shareholder meeting. Ordinary shares are non-convertible, meaning they cannot be converted into preference shares.
Definition of Ordinary Share Capital
Ordinary Share capital is defined as the amount of capital raised by issuing shares of the company on the stock exchange. The capital received by the owners in exchange for the shares is called the ordinary share capital. Ordinary share capital enables your equity ownership in the company. It is a predominant way to finance various projects and is generally considered better than debt instruments. Ordinary share capital is mentioned as equity capital on the liabilities side of the balance sheet. Any time the shareholder decides to sell the shares, the company is entitled to pay at the current market value of the share.
Methods to Evaluate the Value of Ordinary Shares
There are three principal methods of valuation:
1. Asset-Based Method
The asset-based approach is when the company’s net equity is divided by the number of ordinary shares outstanding to determine the value of each share. Net assets or net equity is defined as total assets less the total liabilities. This method is extensively popular among manufacturers, distributors, and capital-intensive companies.
2. Income-Based Method
The Income-based method is further categorized into the Discounted Cash Flow (DCF)method and the Price Earning Capacity(PEC) method. The DCF method uses the discounted value of expected future cash flows to calculate the fair value of each share. The PEC method uses historical earnings data to determine the value of each share.
3. Market-Based Method
The market-based approach uses shares’ market value to evaluate the fair share price. The market forces, business model, and investor sentiments determine the market value of the share. The more the investors are willing to invest in a given company, the higher the market value of the share will be.
Ordinary Share Capital Formula
The ordinary share capital is calculated using a simple formula:
Ordinary Share capital = Issue Price of Share * Number of Outstanding Shares
- Issue Price of the share refers to the Face Value of the share at which it is floated in the stock market.
- The number of Outstanding Shares is the number of available shares to raise the required capital.
Here are examples of ordinary share capital to make understanding easier.
- Suppose XYZ is an Indian company that decides to sell 10000 shares, each with a face value of Rs10. How much will the ordinary share capital be? Using the above formula, the ordinary share capital will be 10000*10 = Rs 100,000
- Suppose ABC is an Indian Company with an authorized capital of 100,000 shares at a book value of Rs 10 each, for a total of Rs 1,000,000. However, the company’s issued share capital is only 10,000 shares, leaving 90,000 shares in company reserve for the future. Using the formula, the ordinary share capital will be 10000*10 = Rs 100,000
In the second example, we do not consider 100,000 shares because the company decides to issue only 10,000 shares.
Advantages of Ordinary Share Capital
Ordinary Share Capital is a flexible way of raising capital because the company can control the number of shares they decide to issue, the price of each share, and when to issue. Unlike debt financing, the company does not have to worry about making interest payments or repaying the initial investment.
The company minimizes its risk of bankruptcy when raising capital through floating shares in the stock market. Shareholders become the company’s owners, and unlike creditors, they cannot force the company towards bankruptcy in case of failure to meet payments. Ordinary Shareholders make maximum gains in case a corporate giant takes over a start-up, as it shoots up the share price, increasing the share capital.
Disadvantages of Ordinary Share Capital
All the shareholders have to pay the price to buy the shares and claim their part of ownership in the company. While it is profitable, it could also be disappointing if you are a short-term investor because the volatile nature of the market leads to fluctuation in prices. In case of bankruptcy, the shareholders may lose their entire investment amount.
Though the shareholders are entitled to dividends, dividends are never predetermined or fixed. They are entirely at the management’s disposal. If the management decides to plow back the profits, ordinary shareholders will not receive any dividend. At liquidation, ordinary shareholders are the last ones paid after meeting all the liabilities.
Limitations of Ordinary Share Capital
While raising capital through floating ordinary shares in the market is a flexible approach, it has its own set of limitations. It often adds to the additional cost of the company to raise capital via this approach. The company has to prepare well for its IPO launch to get the public interested in buying your shares.
Raising ordinary share capital also costs the company its time. Quarterly updates have to be provided to the shareholders concerning the company’s performance and other relevant issues. Raising ordinary share capital may initially shift focus from the actual business. It requires a lot of legal paperwork and formalities, then begins the organization and marketing of the IPO.
Ordinary shares are an integral source of finance for any company, irrespective of its size. While the company enjoys the flexibility of raising capital, they have a lot at stake. Most companies go down this approach to raise capital, but they ensure measuring the pros and cons before making their company available to the public for ownership. Read on about issued share capital.